Dollar tumbles as huge credit crunch looms

The dollar has tumbled to its lowest level ever against the euro and to a 26-year low of $2.06 against the pound as financial turmoil sent US markets tumbling to their worst day’s performance in over four months.

US stocks were left spiralling along with the American currency on fears of broader economic contagion from the sub-prime property slump.

The fall caused London markets to tumble dramatically late in the day. The blue chip FTSE 100 fell 125.7 points to 6498.70, while the FTSE 250, which consists largely of UK-based firms rather than multinationals, plummeted 198.20 points to 11,584. The FTSE was little changed in Wednesday morning trading at 6504.70.

So deep were the concerns about the fate of the US economy, the biggest single engine of global growth, that markets brushed aside US Treasury Secretary Hank Paulson's attempts to allay fears of a sharp US downturn, and reassurance that a “strong dollar is in our nation’s interest”.

"There has been a very significant housing correction. I think we're at or near a bottom there. I don't deny there's been a problem with sub-prime mortgages but it's quite containable," he said.

The closely watched DXY dollar index broke through a crucial support to fall through 80 for the first time since 1995, raising the risk of a disorderly rout as foreign funds pull their money out of the US.

The euro jumped at one point to $1.3852 - the highest level since it was created in 1999. Meanwhile, sterling touched a high of $2.065. By Wednesday's trading, the dollar had recouped more than a cent of its losses against sterling and was back below $2.06. The euro was also strengthened to below $1.38.

David Bloom, currency chief at HSBC, said the dollar had fallen victim to growing fears of a US credit crunch, and likely knock-on effects through debt markets. "Foreigners have made a $2 trillion bet on US credit and now they're discovering it's not as good as they thought," he said.

Mr Bloom said hopes of a brisk US recovery after the winter slowdown were "melting away" as the housing slump continued to hinder consumer spending power. "The concern is that this could spread into equities, which have been insulated so far. Then we have a major problem," he said.

The real spark for concern in equity markets was news of a 33pc fall in quarterly profits at Countrywide Financial, the largest US mortgage lender, which also slashed its full-year profits outlook

USG, the world’s largest seller of gypsum wallboard for home building, gave a similarly gloomy housing outlook.

JP Morgan added to jitters with a warning that US house prices could fall 15pc during the next two years as interest rates on mortgage "teaser" loans adjust sharply upwards, triggering further waves of defaults. It said the damage would continue to spill over into the wider credit markets, where spreads on high-yield debt punched up to two-year highs yesterday.

It usually takes months before widening credit spreads start to infect equities but there were signs yesterday that this may be drawing closer. Daniel Stillit, an economist at UBS, said the squeeze in the loan markets would end the craze for jumbo takeovers by private equity groups armed with debt, which have pushed up stock prices. "Deal sizes are being scaled back, with far-reaching implications for equities," he said.

The pound and the euro have taken the brunt of the dollar's slide since the Chinese yuan is fixed to the greenback by a crawling peg, and the Japanese yen has been held down by rock-bottom interest rates. The failure of Asia to play its full part in the dollar adjustment is causing major imbalances in the global currency system. It has already prompted protests from French president Nicolas Sarkozy. Although sterling touched a high of $2.0650 against the dollar yesterday, it hardly moved against the euro. Roughly 65pc of UK exports go to Europe, which is enjoying a mini-boom. As a result, much of British manufacturing has been sheltered from the strong pound so far.

But the first signs of stress among exporters are starting to appear. The CBI's industrial trends survey released yesterday showed a sharp fall in orders from +8 in May to -6 in June. It said export orders had fallen "noticeably" for the first time in 18 months.

"UK exports had been resolute in the face of a strong pound but a combination of a slower US economy and sharp increases in the price of oil, commodities and freight is beginning to tell for exporters," said Ian McCafferty, the CBI's chief economist.